How to Rebalance Assets while Skipping Past the Perils

Investing savants have ideas for you, ranging from preferred stocks to asset-backed securities.

Reported by Larry Light

Art by Daniel Shaffer


In today’s scary investing world, the goal is to find a grand balance that suits the moment, with the right amount of X assets diversifying from Y assets. A mixture to take your holdings past present dangers into (one hopes) a kinder future. That is the core of economist Harry Markowitz’s Modern Portfolio Theory, but putting it into effect nowadays is way hard.

Amid the turbulent, COVID-19-stricken present, rebalancing for pension funds and other institutional investors is a hazardous journey because no one knows when the pandemic will be over and what the world will look like then. In this environment, “if you think you can quantify risk, you can’t,” said Matt Lloyd, chief investment strategist at Advisors Asset Management.

So we asked smart asset owners and managers what they are doing. Many are backing away from big stock holdings, on the theory that the late-lamented 11-year equity bull market, now in a curious revival, won’t keep on keeping on.

Sam Masoudi, CIO of the Wyoming Retirement System ($8.5 billion in assets), cut his fund’s stock portion during the winter and the COVID onset to 46.5%, down from the 49% level the fund listed in its mid-2019 annual report. Some others are going out further on the risk curve: The California Public Employees’ Retirement System (CalPERS), with $400 billion in assets, is ramping up its private equity investments and leverage.

Indeed, after the shock of the financial crisis and the Great Recession, the makeup of public pension plans has shifted away from stocks, and also to a lesser degree from bonds, the traditional stalwart opposite number to equities.

In a 2019 report by Wilshire Consulting, stocks were 47.6% of public plans’ portfolios on average, compared with 56.9% in 2008. The portion of bonds was down less dramatically: 23.7% recently, versus 27.6% for 2008. Over the same time, private equity (PE) and real estate had doubled their representations, to 10.2% and 12.9%, respectively.

Meanwhile, corporate defined benefit (DB) plans have gone for a decidedly more conservative allocation. By the reckoning of Milliman consultants, over the comparable period, fixed income’s share grew to 49.1% from 39.3%, while equities shrank to 32.5% from 45%. The Milliman study’s “other” category, which includes PE and real estate (sub-categories aren’t broken out), expanded slightly to 18.4% from 15.7%. Unlike those in the public sphere, company plans are often into liability-driven investing (LDI), which puts more of a premium on reducing risk.

What Is To Be Done?

In his famous 1902 pamphlet, Russian leader Vladimir Lenin laid out how communism was to triumph in czarist Russia. Titled “What Is To Be Done?” the piece argued that drastic change was necessary—namely, a violent revolution—for a worker’s paradise to arrive.

For today’s investment leaders, who are thorough capitalists and lack Lenin’s bloodthirsty bent, rebalancing nevertheless requires a yen to go beyond traditional comfort zones. The corporate LDI movement is a part of that mindset.

In that spirit, possible plays are:

Tech stocks beyond market heavyweights. The likes of Apple, Amazon, Microsoft, and their ilk have had a disproportionate impact on the stock market. But they’re not the whole story. Looking at the sector as a whole, it’s hard to dispute that tech writ large is at the heart of the future.

Allen Kim, manager for research and investment solutions at Kayne Anderson Rudnick, likes an exchange-traded fund (ETF) named ARK Innovations, which contains a bunch of smaller tech comers. The fund is up 56% this year. “These are fast-growing tech innovators,” he said. Gene editing therapy firm CRISPR Therapeutics, streaming device maker Roku, and mobile wallet provider Square are some of its most prominent holdings. The biggest of them is electric car company Tesla.

Non-China emerging markets (EM). Indexes or individual stocks in these places, if wisely chosen, should bear fruit. The trade war between China and the US shows no sign of easing. Even if Democrat Joe Biden is the next president, tensions are sure to persist, owing to Beijing’s belligerence and human rights abuses.

As a result, many multinationals are withdrawing from China, putting their supply chains in smaller EM economies that sport rapid growth and lack China’s swaggering ambitions on the world stage. India and Vietnam are the likeliest beneficiaries, noted Lloyd of Advisors Asset. “This won’t happen overnight,” he said, but the trend is in that direction.

Alternatives with some funk on them. To wit: cannabis and gold. Those are the recommendations of Noah Hamman, CEO of AdvisorShares  (the “funk” description is ours, not his). There is a wave of legalization and decriminalization happening for pot among the states. With the product legal in 11 states thus far, Hamman’s firm has launched an  marijuana ETF called YOLO (for, “you only live once”). Cannabis stocks are down lately, yet no doubt have high prospects.

Physical gold is doing very well, which is often the situation when cold economic winds blow. While the yellow metal has a lot of detractors, it has shot up 16% since the epidemic’s February onset. This is a volatile commodity and pays no dividends or interest. Still, a number of advisers say you should keep a small helping in your portfolio, as an offset to nasty times.

Asset-Backed Securities (ABS). This segment includes everything from mortgages to auto receivables. To Jason Brady, CEO of Thornburg Investment Management, these instruments are a good stealth opportunity. “They are not covered by indexes or ETFs,” he said. Many have de-levered and so have reduced their risk. Unlike their more exotic forbears, which often came to grief in 2008, ABSs nowadays don’t tend to have layers of increasing risk.

The province of hedge funds and mortgage real estate investment trusts (REITs), ABSs sometimes have relatively decent yields. A Morgan Stanley ABS fund pays 3.8%, as of June 30. Their solid structure is reassuring: Citigroup, for instance, has a pool of mortgages with a good loan to value (75%) and borrowers with top-notch (750) credit scores, Brady said. The expectation is that default rates for the underlying loans won’t explode. 

Preferred stocks. These are often overlooked, as they live in the no-man’s land between stocks and bonds. Kim of Kayne Anderson Rudnick likes them because they “are higher on the capital stack,” meaning they are better ranked than common stock in a bankruptcy case. You might even get some money back.

Better, preferreds usually have yields in the mid-single digits. Goldman Sachs launched an issue that pays just under 6%, at a time when the 10-year Treasury yield is 0.65%. Financials are the biggest preferred issuers, and if you have confidence in banks (given their strong capital cushions, that’s plausible), they could round out your income needs.

How to Reshuffle Assets

Certainly, any rebalancing plans are tenuous, and markets have humbled many a financial genius. As prizefighter Mike Tyson put the matter, “Everybody has a plan until they get punched in the mouth.” 

The timing of a plan is crucial, of course. Rebalancing should occur at regular intervals, if only to restore the proportions in the plan, said Sheldon McFarland, vice president of portfolio strategy and research at Buckingham Wealth Partners. “It needs to be rules-based—whether it occurs quarterly or annually,” the shifting period should be consistent, he argued. “Asset allocation shouldn’t be based on what the market does. Then, you’re acting on instinct.” And you’ll be sorry.

Not all rules are worthwhile. One enticing, yet problematical, approach to rebalancing is to chuck the lowest performers each time assets are re-mixed. “Human nature says that the ones with the worst returns are a bag of garbage,” said David Aspell, a portfolio manager at Mount Lucas Management. Over time, that ruins your diversification, he warned. “You end up with a momentum portfolio.”

Amid heated volatility, the stock market has had wild ups and downs. While nowhere near its apex in March, of 82.6 on the CBOE Volatility Index (VIX), it nudged up to 32 on Monday amid a small downturn in the S&P 500. Stocks show broad, maybe too broad, dispersion: Value stocks are off by 15% this year, after almost pulling even with growth stocks at year-end 2019. Now, growth is 11% ahead.

Turbulence, though, is omnipresent. Case in point: commodities are down 18.5% this year. Fixed income, typically the unperturbable cousin to equities’ ever-excitable Mr. Market, has had its own crazy ride. The Bloomberg Barclays US Agg, representing the entire US investment grade universe, took a 6.2% slide in March, and recovered once the Federal Reserve rode to its rescue. Currently, the bond index is up 6.7% on the year, versus the S&P 500’s 2.3% in the red.

Hazards on the Route

Rebalancing is occurring amid the enervating awareness that recessions are historically unkind to pension funding. A number of them are still living with the ill effects of the 2008 financial crisis. Example: the deeply underfunded Illinois system, where Democratic lawmakers are pushing for a $10 billion federal bailout. The state’s five retirement plans are 40% funded, a shortfall of $137 billion.

Pensions have lived in the shadow of the financial crisis, and now another shadow has come along. The 2008-09 market decline reduced public pension fund assets by more than 20% and, at the same time, lowered combined state and local government revenues by more than 10%, harming contributions to the retirement programs, according to the National Association of State Retirement Administrators.

The overall funded ratio for the 100 largest US public defined benefit pension plans was 74.9% at year-end 2019, down from 84% in 2007, right before the debacle, according to actuarial and consulting firm Milliman. The average corporate plan funded ratio, as of year-end 2019, was 87.5%, off from a peak of 106% in 2007, another Milliman survey found.

Whatever pension chiefs and other institutions are doing now, the hope is that altering the composition of their holdings will see them through to better times. A robust plan should help them avoid mistakes, the reasoning goes. Done properly, Mount Lucas’ Aspell said, “rebalancing saves you from yourself.”

Related Stories:

Hooray, LDI Is Progressively Making Corporate Pension Portfolios Less Risky

CalPERS Revises Fixed Income and Public Equity Investment Policies

T. Rowe Study: Rebalancing Even in a Market Fall Is Vital

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Asset Allocation, asset-backed securities, CalPERS, Cannabis, Emerging Markets, Funded Ratio, gold, preferred stocks, rebalancing,